W. Scott Simon
Good grief, the interest in the different flavors of fiduciaries under the Employee Retirement Income Security Act of 1974 continues unabated. The feedback that I’ve received about this column over the last few months has been exceptionally strong. Likewise was the reaction that I received after participating recently in a Web seminar [www.fi360.com/webinars] discussing an ERISA section 3(38) fiduciary and an ERISA section 3(21) fiduciary. The 3(21) refers to the kind of fiduciary that can be characterized as “limited-scope,” “nondiscretionary,” “limited service” or some other such term to distinguish it from “the” 3(21) “Named Fiduciary” named in the plan document.
Before delving into these subjects next month even more than I’ve done already–if that’s possible (yes, folks, it’s possible), I thought that it might be a good idea this month to focus on the limited-scope ERISA section 3(21) fiduciary. Some regular readers of this column may have gotten the impression that I don’t think too highly of such fiduciaries. Not so, grasshopper.
Limited Scope 3(21) Fiduciaries From the Dark Side
It’s true that I’m not too fond of those limited-scope 3(21) fiduciaries that engage in sophisticated marketing campaigns and sales processes to actively convince gullible plan sponsors to believe (or do nothing to dissuade them from believing) that by retaining them, the sponsors will be relieved completely of significant fiduciary responsibilities (and therefore liabilities) or that such responsibilities and liabilities will somehow be mitigated through the participation of these fiduciaries. It’s no surprise why many plan sponsors would come to these conclusions considering the cleverness of the marketing programs put in place by such fiduciaries.
Limited Scope 3(21) Fiduciaries With the White Hats
But there are many other advisors acting as limited-scope 3(21) fiduciaries (and even nonfiduciary advisors, for that matter) who are straight up with their plan-sponsor clients from the outset and make crystal clear to them that they can only advise, help or assist the sponsors, or make recommendations to them. These advisors make certain their clients understand that it is the clients who ultimately bear sole responsibility (and liability) for selecting, monitoring and replacing plan investment options. And if participant lawsuits start flying through the air, they remind them, it is ultimately only the sponsors that have the potential for catching it in the shorts, not the advisors (even in cases where the advisors–at least for awhile–get to share in the many delights of depositions).
Some of these advisors know and some don’t know why they can assume only an advisory role vis-à-vis their plan sponsor clients, and not a decision-making role. (The reason, for the record: “discretion” is the great demarcation point in ERISA between making decisions and taking actions for which there is legal accountability and risk, compared to providing advice that must be legal, appropriate and unbiased but for which the advice-giver does not legally share in the risk of making any actual decisions.) But these advisors, given their fiduciary mindset of placing the interests of their plan sponsor clients (as well as, by logical extension, those of plan participants and their beneficiaries) first, seem to me to be particularly close to their plan sponsor clients and for that reason are in the enviable position of being able to influence them for the better. This is true even though a limited scope 3(21) fiduciary has no discretion of any legal consequence under the law of ERISA. (To the extent that a 3(21) does have discretion, it’s temporary and limited to a specific function to be performed by the 3(21) based on the defined scope of the delegation conferred on the 3(21) by the plan sponsor or the ERISA section 3(21) named fiduciary.)
The “white hat” advisors that I’ve described here can have a lot of sway with their plan-sponsor clients, and, because of that, they can steer them toward a solution that will significantly reduce the sponsors’ legal burdens–and help increase the odds that the retirement income security (the RIS in ERISA) of their participants (and the beneficiaries of the participants) will be enhanced.
The Solution: Outsource to a Prudent, Qualified ERISA Section 3(38) Investment Manager
One of the few ways to actually bring this solution to realization is for such an advisor to become an ERISA section 3(38)-defined “Investment Manager” through a written contract with the plan sponsor in which the advisor formally acknowledges its new fiduciary status. This transforms a limited scope 3(21) fiduciary from someone who gives legally unaccountable advice into someone who makes decisions and takes actions that are legally accountable. This is a huge step, though, which is why, in my opinion, very few advisors will ever decide to take it.
An alternative for those limited scope 3(21) fiduciary advisors who wish to bring a true value-added solution to their plan sponsor clients is to suggest to their clients that they retain a prudent, qualified 3(38) fiduciary. It’s obvious, of course, that bringing on board such a 3(38) to legally relieve a plan sponsor of its duties (and any corresponding liabilities) to select, monitor and replace a plan’s investment options is of enormous significance to the sponsor. If you don’t believe this, consider that virtually all ERISA litigation involving plan sponsors (other than that pertaining to administrative issues) includes, in some way, the investment options in a 401(k) plan and the allegation that they’re imprudent.
While the effect of bringing in a prudent, qualified 3(38) investment manager fiduciary is highly beneficial to a plan sponsor, what would the effect be on a limited scope 3(21) fiduciary? Wouldn’t the 3(21) feel that if a 3(38) came on board it would somehow “lose control” over a plan’s investment options? There are a number of reasons why a 3(21) shouldn’t feel this way and, instead, should welcome the 3(38).
First, in the traditional retirement plan consulting relationship between a plan sponsor and a 3(21) advisor, the 3(21) assists and helps the sponsor with investments and yet it is still the sponsor that is solely responsible (and solely liable) for any final investment decisions. But sometimes courts assign fiduciary responsibility (and liability) for decisions about plan investment options to a limited scope 3(21) advisor in cases where its plan sponsor client is particularly unsophisticated. Having a prudent, qualified 3(38) fiduciary on board can eliminate this risk for the 3(21) advisor.
The symbiotic relationship among the three entities involved–the limited scope 3(21), its plan sponsor client and a prudent, qualified 3(38) investment manager–helps ensure that all duties are assigned in writing and legal responsibility is apportioned clearly. The appointment of a 3(38) allows the 3(21) to still assist and help its plan sponsor client but the legal responsibility and liability for selecting, monitoring and replacing plan investment options no longer resides in the sponsor and there’s no possibility that it can legally default to the 3(21). Each party clearly understands their roles in this legally clean arrangement so that there are no misunderstandings.
Second, the interaction between the plan sponsor clients of a 3(21) and a 3(38) is minimal. A prudent, qualified 3(38) is a professional independent appointee that acts in concert with other plan fiduciaries. The 3(38) is a professional decision-maker that works closely with a limited scope 3(21) to provide the best investment solutions possible for the participants in a qualified retirement plan. In a good fiduciary relationship that’s properly understood, a 3(21) will find it refreshing to work with a professional decision-maker. Such a 3(21) will therefore not feel that it has “lost control” over a plan’s investment options when a prudent, qualified 3(38) has been appointed by the sponsor.
Or perhaps a limited-scope 3(21) would feel threatened or its value had somehow dimmed in the eyes of its plan sponsor clients if a prudent, qualified 3(38) came on board? This is improbable for a number of reasons. First, it’s the 3(21) advisor–not anyone else–that would be alerting its client to a legally meaningful opportunity to have a professional fiduciary take away a significant amount of the client’s overall fiduciary risk. That alone should make a 3(21) look like a hero in the eyes of its client. Second, while bringing in a prudent, qualified 3(38) significantly reduces the fiduciary burden on the 3(21)’s client, the 3(21)’s normal day-to-day interaction with the client not only remains largely the same but, in fact, it’s enhanced, because a sponsor that has delegated responsibilities and liabilities to a 3(38) fiduciary acquires the duty to monitor the 3(38). A 3(21) can help the sponsor carry out its monitoring duty by providing an independent source of information on the 3(38).
Some would say that this legally meaningful solution somehow “complicates” the investment process. Au contraire: It actually simplifies and streamlines it. For example, when a prudent, qualified 3(38) investment manager fiduciary is appointed, members of the plan sponsor’s investment committee no longer have to go cross-eyed every quarter (or every month) reading reams and reams of investment reports that many don’t understand anyway. Long and cumbersome investment committee meetings where decisions never seem to get made are eliminated. These headaches now become those of the 3(38) because it has accepted the delegation of legal responsibility (and liability) to select, monitor and replace the plan’s investment options.
Others would say that this is all very well but the costs of a 3(38) investment manager must be astronomical. I have had more than one sophisticated ERISA attorney tell me that his or her clients find the idea of appointing a 3(38) mighty attractive but that they’re scared off by the enormous cost involved. When I ask such attorneys how they handle this fear, they reply by asking me how high can these costs really go. Oh boy.
A limited-scope 3(21) advisor that introduces its plan sponsor clients to the legally meaningful solution of appointing a prudent and highly qualified 3(38) investment manager fiduciary can be confident that the low cost, highly diversified investment options brought in by such a 3(38) will more than (usually a lot more than) offset the (surprisingly) low cost of the 3(38).
The reason for this confidence is that a prudent, qualified 3(38) fiduciary, like the fiduciaries of defined benefit plans, is keenly aware of its duty under ERISA section 404(a)(1)(A) to keep costs reasonable and appropriate in relation to the services for which they’re expended as well as its ERISA section 404(a)(1)(C) duty to diversify (preferably broadly) in order to avoid the risk of large losses. And just like fiduciaries of defined-benefit plans, a prudent, qualified 3(38) knows that its behind is legally and financially on the line which is precisely why it’s motivated to bring to a qualified retirement plan an outstanding line-up of investment options low in cost and broad in diversification. Because of that, such a plan will perform similar to the average defined-benefit plan, which studies consistently show achieves higher returns than the average defined-contribution plan. Compare this kind of plan created by a prudent, qualified 3(38) fiduciary for plan participants (and their beneficiaries) with the nightmare of a plan created for more than 1 million participants (and an untold number of their beneficiaries) by Wal-Mart.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.